Inflation can be confusing. Really confusing.
Is there too much? Too little? Is the Fed crazy? And compounding the complexity is the veritable alphabet soup of terms economists use to describe it: CPI, PPI, PCE, “core”, “headline” and so on.
With such copious amounts of data muddying the waters, it's easy to lose sight of why inflation even matters in the first place.
So, let's keep it simple -- really simple -- and put ourselves in the shoes of everyone’s favorite “Sesame Street” character: the fuzzy blue Cookie Monster, or “CM” for short. He’s a low-maintenance type of monster with a singular necessity, making him the perfect subject to analyze when pondering the impact of inflation. Let's also turn back the clock 30 years to the high-flying 1980s.
CM lives a pretty sweet life. He eats cookies for a living, and gets paid $288.78 on a weekly basis, which is what the Bureau of Labor Statistics [BLS] says the average American worker earned in April of 1981. Income, for this story, is kept in so-called constant dollars, which makes it easier to think about how changes in cookie prices affect CM without inflation itself distorting the picture.
Since CM isn't an economist, what matters to him most is how much of his income is left after he buys his one true essential: yummy cookies. In fact, being the monster he is, CM consumes eight pounds, or roughly 18,000 calories, a day.
A one-pound box of cookies ran CM $1.67 in 1981, according to the BLS. Do a little math, and it turns out CM has $195.20 left over after spending $93.58 on cookies at the end of the week to buy the various and sundry other items he enjoys eating, such as typewriters and magic wands.
Fast forward three decades. The prices of many items that go into making cookies have appreciated considerably. That's tightened cookie-makers’ margins just a little too much, and has forced the manufacturers to pass higher prices onto consumers, like our friend CM.
It now costs CM $3.29 to buy a pound of cookies, pushing his weekly cookie cost up to $184.13. Even though he's making $294.21 a week now, his leftover income is only $110.08 – $85 less than he had left over before. Well, that's a problem for CM and he's faced with a couple choices that many Americans are left with today.
One option, especially if he thinks price increases are temporary, is he can simply tighten his belt and buy less stuff. If he does that, there’s a chance it will soften demand for all of the companies from whom he purchases. Ultimately, when millions of people follow this line of reasoning, it’s going to cut those firms’ bottom lines and they’re going to have to make some tough choices to cut back on costs.
Since it seems like the cost of many ingredients that go into cookies are stuck at elevated levels, one clear option is reducing payrolls. This is problematic, because when it occurs on a large scale, it leads to rising unemployment, which in itself, can weaken demand and hit broader economic expansion.
Fortunately, it’s possible that the reduction in overall demand will be sufficient to reduce the rate of inflation. After all, if you hold supply constant and demand ebbs, prices should theoretically go down.
But what if CM thinks the inflation is permanent, and is even going to rise further over the next several years? The Federal Reserve often refers to this process using the technical phrase: “inflation expectations becoming unanchored.”
“We hope this situation never happens,” said Josh Feinman, global chief economist at DB Advisors, Deutsche Bank’s institutional asset management business.
The reason the unanchored inflation expectations are so troubling, according to Feinman, is that it creates a “self-fulfilling” spiral.
If CM truly thinks prices are going to be going up over the next several years, he’s likely to ask his employer to boost his pay. For his employer to afford the pay increase, it will likely have to raise its prices. When this ripples through the rest of the economy, the effects multiply, causing a dangerous, and long-lasting, rise in prices.
In turn, that could lead to a situation called stagflation, wherein unemployment and inflation rise together and the economy fails to expand. The U.S. experienced such a situation in the 1970s when the oil crisis, coupled with loose monetary policy, stoked increases in the rate of inflation.
Ironically, escaping stagflation would mean the Fed would have to take measures like hiking interest rates, which would likely have adverse effects on the economy. In particular, it could slow economic growth and exacerbate the unemployment problem for a sustained period.
The Fed has learned a lot since CM's early days and “cherishes” its ability to keep inflation expectations in check, Feinman said, adding that low inflation expectations create a “positive feedback loop” that helps keep them in check.
Still, with so many variables potentially affecting sentiment, it’s impossible for the Fed to have perfect control over inflation expectations, meaning the specter of inflation will continue to loom.